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Where do we stand with exchange rate regimes?

Over the last 30 years, Latin America has been among the most volatile regions in the world. There is growing evidence that macr­oeconomic volatility hampers economic growth, by reducing physi­cal and human investment.2 In fact, several studies3 show that re­ducing Latin America's volatility to the levels of industrial countries (i.e., two or three times below) would increase the region's economic growth by one percentage point a year.

There are many explanations behind the region's high macr­oeconomic volatility, among which its large dependence on external capital flows, the concentration of exports in commodities, and the all-too-frequent changes in economic policies, particularly exchange rate regimes. In this article, I shall concentrate on the latter, acknowl­edging that exchange rate regimes are only one of the several macr­oeconomic policies that can reduce volatility and, thereby, enhance growth.

After the collapse of the Bretton Woods system, Latin America moved from flexible to fixed exchange rate regimes, mainly as a tool for macroeconomic stabilization. This strategy was put into ques­tion with the Mexican crisis, and clearly faltered with the Asian cri­sis, since it was perceived as having allowed for an excessive accu­mulation of risks. Since then, and in the context of increasing glo­balization, the world has moved toward a bi-polar view of exchange rate regimes. On the one hand, mostly large and credible. enough countries have moved toward more flexible exchange rate regimes, generally coupled with direct inflation targeting, to anchor expecta­tions. On the other, small countries in need of importing credibility - generally after a crisis - have introduced fixed exchange rate re­gimes in the form of currency boards and, more recently, unilateral official dollarization.

Throughout this time - and notwithstanding the changes in the exchange regime choices - the dollar has been the only currency used as an anchor in the region. This is explained not only by the economic and financial preponderance of the United States in the Western Hemisphere, but also by the absence of a suitable alterna­tive. Whether the introduction of the euro will change this situation is an open question.

The difficulties experienced in the region in the last two years shows that no exchange rate regime can insulate a country from large macroeconomic volatility. Argentina learned that one cannot buy discipline by tying one's hands with a currency board. Brazil learned that a flexible exchange rate regime is a useful adjustment tool for the current account but can lead to difficult debt dynamics if the exchange rate is key in the setting of financial contracts. From Uru­guay's experience, intermediate exchange rate regimes do not seem to be much better. Finally, the experience with official dollarization is too recent to make a judgment but Ecuador's recent financing problems - in a period of high oil prices - calls for caution.

The question, then, is whether there are other options available that have not yet been explored, which could reduce Latin Ameri­ca's macroeconomic volatility. From a European perspective, the obvious one is regional monetary integration, and ultimately a mon­etary union. Considering this option, at least in theory, becomes more relevant in light of globalization and a possible move toward a more bi-polar international monetary system with the introduction of the euro.

A regional monetary union could be analysed as a South-South monetary integration or a North-South one (i.e., including the United States). The latter is more appealing but also less likely- at least if conceived as a 'symmetric' monetary union as the European' Mon­etary Union is. For this reason I shall focus on the former.

Pros and Cons of Latin American Monetary Union

When compared to other exchange rate regimes, a Latin American monetary union would have a number of advantages - and disadvantages - worth mentioning. The main advantage is that it would foster economic and financial integration. In fact, the lack of economic integration, which was one of the main reasons to dis­card a monetary union as a feasible option in the literature of Opti­mal Currency Areas, seems now less important thanks to the research developed by Frankel and Rose in 1998. They find that the process of economic integration among different countries may be endog­enous to the establishment of a monetary union. It should be noted, though, that the endogeneity argument is also valid in the case of unilateral dollarization, but to a lesser extent because the degree of nominal and real convergence will tend to be lower with the United States than with other Latin American countries.

As an additional step to economic integration, whether a mon­etary union would also lead to political integration is an open ques­tion,4 and even more so whether it would be beneficial for the region as a whole.

There are, however, some clearer advantages in the political sphere, not related to political union, which could be obtained from a monetary union when compared with dollarization. A regional monetary union would imply creating a new currency for which all participating countries are jointly responsible, rather than accepting the currency of another country without conditions. This means that Latin American countries would not have to give up the control of monetary policy but rather share it with the other members of the monetary union. How advantageous it is to 'share' is more of an economic than a political issue. In fact, it depends on how similar the preferences of the countries involved are, in terms of the objec­tives to be achieved. It also depends on how many instruments are put in place to achieve nominal and real convergence among partici­pating countries. Based on the European experience, a system of income transfers from winners to losers could serve as a basis to increase the advantages for all, on average. How disadvantageous it is as opposed to 'giving up' monetary policy will depend on the rela­tive loss of credibility, as opposed to accepting a stable and safe currency, such as the dollar. The lack of credibility is indeed one of the major disadvantages of a regional monetary union, when com­pared with dollarization, because of the absence of an anchor coun­try in the region with a long track record of price and exchange rate stability. This is probably the main difference between the European project and the monetary integration process, which could emerge in Latin America.

There are other two advantages of a regional monetary union when compared with dollarization. The first is that seignoirage is not lost but shared. Such loss is not negligible; at best 0.3 percent of GDP in countries with low inflation and widespread dollarisation.5

The second is that the central bank lender of last resort functions could remain decentralized, albeit subject to coordination rules, as has happened in the euro zone. This is a particularly relevant advan­tage for Latin American countries because of the frequency of bank­ing crises.

Another aspect, which could in some cases constitute a disad­vantage and in others an advantage, relates to the process of achiev­ing a monetary union. As the European experience reveals, in order to ensure the successful launch of a common currency, a prolonged and sometimes difficult process of working toward the necessary convergence of macroeconomic policies might be needed. This im­plies a subordination of domestic economic policy priorities to the objective of establishing a regional monetary union. For virtuous countries this constraint might be a disadvantage but not for those in need of reforms. In fact, the commitment to monetary union could provide the necessary outside 'constraint' to pursue prudent domes­tic macroeconomic and structural reforms, a kind of external push­factor that gives justification and credibility to sometimes-painful domestic policy choices.

Finally, the main problem with this option is probably time. A Latin American monetary union is certainly a slower option in terms of implementation than any other. Not that it would be unfeasible to create a monetary union in a short period of time but it would prob­ably be a failure because of the lack of convergence. Even the strongest supporters of a regional monetary union - which are very few - re­gard a timeframe of at least fifteen years a necessary transition pe­riod before a well-functioning monetary union can be established, and they usually only refer to a sub-group of countries, namely Mercosur.6 It seems clear that slow solutions for countries with ur­gent problems tend not to be considered, rightly or wrongly.

Some Lessons from the European Experience

While the prevailing circumstances in Latin America are clearly different from ihose in Europe when the monetary union was designed, there are still some useful lessons to be drawn. This is particularly so if one recalls that the euro area was far from fulfilling what the pundits considered necessary criteria to become a mon­etary union. Even now, a good part of the literature would argue that euro area countries do not constitute an optimal currency area.

The first lesson is that a good deal of planning and time is needed for such a project. European economic integration has been a gradual process, driven forward by a number of factors, which sometimes pushed in opposing directions. First, there were political and geo-strategic factors, which set the general frame of reference. In particular, the common experience of the devastating effects of World War II led to a 'shared national trauma,' which orientated coun­tries into a cooperative mould. In fact European integration has been - and remains - wider in scale than economic welfare, since it ulti­mately aims at ensuring peace, stability and prosperity ort these con­tinent. Outside pressure also reinforced this dynamics.

Latin American countries have been fortunate not to be at the epicenter of one of the worst conflicts of the 20th century. In addi­tion, their geo-strategic position placed them somewhat at the fringes of the Cold War bi-polarity. The less pressing geopolitical factors explain, at least in part, the scarce interest that Latin American gov­ernments have had for regional integration. However, there is a dif­ferent type of 'shared national trauma,' which should not be under­estimated, namely the prolonged economic policy failures, i.e. high or hyperinflation, under-development, debt crises, and the hardly accepted economic preponderance of the United States.

Second, European economic integration has been pushed for­ward to the stage of a currency union because further integrative steps were viewed by Member States as coinciding with their na­tional interest or even as part of a 'national project.' Similarly, vari­ous interest groups have linked, in one way or another, their indi­vidual interests to European integration. This is not so obvious in relatively closed countries, as most Latin American ones are, with a commodity concentration of exports. However, the liberalization proc­ess that started with trade in the late 1980s and continued with the domestic financial system and the capital account shows that Latin American countries - or perhaps international organizations which associated their lending to such reforms - are aware of the gains from integration. However, this process has lacked the ambition for greater scope and depth, except for some visionary rhetoric.7 In fact, as far as a national project can be discerned in individual Latin Ameri­can countries, it becomes obvious that their longer-term national ambitions are far from being aligned with ideas of deeper regional integration, though it is possible that a number of countries might reassess their interests as a way to face the challenge of globaliza­tion. In other words, as long as regional integration initiatives in Latin America lack the ambition to go beyond mere free trading zones - and thus avoid the necessary real transfer of sovereignty and the subordination of national economic policy to common rules and ob­jectives – exchange rate volatility is likely to remain, except for those countries which opt for the quick fix: dollarization.

Third, while Europe was not considered an optimal currency area when it embarked in the EMU, it did take bold measures to increase nominal and real convergence. The first was achieved by setting the Maastricht criteria to accede the EMU. This kick-started a process of fiscal consolidation and disinflation, which would have been necessary anyway. The second was enhanced through income transfers from the richer to the poorer countries. It is clear that Latin America is still far from being an optimal currency area8 but it is also true that the necessary steps have not been taken yet to converge in real and nominal terms. The European experience shows that there are ways to increase convergence, even if sometimes politically dif­ficult to implement.

A final crucial insight to be gained from Europe's integration is the systemically important role of common institutions. The lit­erature on institutions and institution-building in international rela­tions theory9 has amply described the beneficial effects and merits of common institutions as setters of common principles, norms and procedures, as generators of information, as a focus of socialization and as an instrument to build up trust and confidence. This has clearly been the case in Europe where supranational institutions have con­tributed to broader and deeper integration, not least because of those institutions' bureaucratic self-interest. Such a pro-active role applies in particular to the European Central Bank and the Commission, which not only carry out already centralized policies (most impor­tantly monetary policy) but also act as a policy initiator, unbiased agenda setter and neutral guardian of the Treaty.

By contrast, Latin American integration projects are not en­dowed with common institutions, even in the most advanced case, Mercosur. Indeed, there is still no recognition that the benefits of institution building to speed up the process of economic integration outweigh the loss of national sovereignty. If the political will to cre­ate regional institutions existed, there would be a need for the stronger countries to foster the process. Brazil could conceivably play the role of 'guarantor' of the co-operation arrangement and the uphold­ing of its rules but it is hampered by economic and political instabil­ity. The project of a free trade area for the whole western hemisphere also reduces the interest of creating regional institutions.

In sum, in a time where Latin American countries are running out of options to reduce macroeconomic volatility, a monetary union would seem an appealing idea, at least in theory. A cursory look at the pros and cons of such option indicates that the lack of an anchor country that can export credibility, is probably the main difficulty to take this option seriously. However, the European experience shows that the situation was not necessarily much better when the first steps towards integration were taken. What seems clear is that a Latin American monetary union cannot be considered a quick fix to re­duce the region's vulnerability but rather a long-term project whose advantages and disadvantages should be pondered carefully before embarking on it. If the advantages do outweigh the costs, a strong political will of Latin American national governments is absolutely crucial to move toward - slowly but steadily - a monetary union.